IRS Provides Guidance on What Constitutes a Covered Employee under Code Sec. 162(m)

Internal Revenue Service|Tax|Tax Reform

By Sean Duesing

On August 22, the IRS issued Notice 2018-68, providing guidance on the application of section 162(m), which generally limits the amount of a deduction that publicly held corporations can claim for compensation paid to certain employees earning in excess of $1 million. The Tax Cuts and Jobs Act (TCJA), effective for tax years beginning after December 31, 2017, significantly altered the regulations under Section 162(m) by modifying the definitions of “covered employee,” “compensation” and “publicly held corporation.” Notice 2018-68 will serve to assist taxpayers by providing a definition of a covered employee for purposes of Code Sec. 162(m)(3), defining what constitutes a binding contract under the Grandfather Rule, and defining what constitutes a material modification of a binding contract.

As per the TCJA,

covered employee is any employee of the corporation who:

  • is the principal executive officer or an individual acting in such capacity at any time during the tax year;
  • is the principal financial officer or an individual acting in such capacity at any time during the tax year;
  • is among the three highest compensated officers for the tax year (besides the principal executive or financial officer); or
  • was a covered employee of the corporation (or any predecessor) for any prior tax year beginning on or after January 1, 2017.

Applicable employee compensation (remuneration) includes any cash and noncash benefits paid for services, including commissions and performance-based compensation. It does not include:

  • income from specified employee trusts, annuity plans, pensions, or any benefit that is reasonably anticipated to be tax free;
  • income payable under a written binding contract which was in effect on February 17, 1993; and
  • compensation paid before a corporation became publicly held.

Amendments to Section 162(m) made by the TCJA do not apply to remuneration payable under a written binding contract that was in effect on November 2, 2017, and which is not modified in any material respect on or after such date. The transition rule (Grandfather Rule) applies to a written binding contract that was renewed after November 2, 2017.  A written binding contract that is terminable or cancelable by the corporation without the employee’s consent after November 2, 2017, is treated as renewed as of the date that any such termination or cancellation, if made, would be effective.

TCJA amendments to Section 162(m) will apply to any written binding contract that is materially modified after November 2, 2017. A material modification occurs when the contract is amended to increase the amount of compensation payable to the employee. A modification of the contract that accelerates the payment of compensation is a material modification unless the amount of compensation paid is discounted to reasonably reflect the time value of money. If a written binding contract is materially modified, it is treated as a new contract entered into as of the date of the modification.

As described above, the TCJA amendments to Section 162(m) apply to taxable years beginning on or after January 1, 2018. It is generally anticipated that the guidance in Notice 2018-68 will be incorporated in future regulations that, with respect to the issues addressed in this notice, will apply to any taxable year ending on or after September 10, 2018.

The Treasury Department and the IRS anticipate issuing further guidance on other aspects of Section 162(m), including the effects of the Act’s amendments. Accordingly, the agency is requesting comments on additional issues that future guidance should address.

Schneider Downs will continue to monitor guidance issued by the Treasury and IRS regarding the Tax Cuts and Jobs Act and will provide you these insights in a timely manner. As always, if you have any questions about statutory or administrative changes and how they impact you, please don’t hesitate to contact us.

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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

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